DP17079 Revisiting the omitted price bias in the estimation of production functions
We revisit the bias in the estimation of production functions with firm-level data due to the lack of physical quantities on output and inputs. We show that constructing firm-specific prices from available data on firm-specific price changes, and using them to deflate revenues and expenditures, introduces a measurement error into the empirical production function. This error reflects the unobserved base year prices used in the construction of the firm-specific prices. The usual practice of ignoring them generates an omitted variable bias (OVB). Monte Carlo simulations suggest that this bias can be significant. Because of the OVB, the estimates are sensitive to the choice of base year. The OVB disappears in our simulations when firm-specific fixed effects are incorporated into the estimation of the production function.
